Fed Up! What Small Businesses Should Expect as Monetary Policy Changes

By Adam C. Uzialko, Writer March 13, 2017 02:13 pm EST

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The Federal Open Market Committee (FOMC) is preparing to meet on Mar. 14, as expectations abound that the Federal Reserve will move to raise interest rates, if not now, then certainly in the near term. If the Fed indeed makes these policy moves, what would that mean for business owners? How might the markets react? What might it mean for consumer demand?

To find out more about what the Federal Reserve's impending changes mean for the economy at large, and for your business and investment portfolio, Business News Daily spoke with economists who are keeping an eye on the U.S. central bank.

The current state of the Federal Reserve

Since the financial crisis of 2008, the Federal Reserve dramatically lowered the interest rates at which banks borrow money. Low interest rates incentivize borrowing and spending, and debt is far cheaper to acquire.

The low rates are intended to kick-start a sluggish economy by encouraging consumers and businesses to continue buying and investing, rather than clutching their pearls during a crisis. The Fed achieves this boost by increasing the size of its balance sheet by buying securities from banks, such as U.S. treasury bonds, thus injecting more cash into the economy. The interest rate was held down near zero for years until Dec. 2016, when the central bank began to gradually raise rates. According to the St. Louis Federal Reserve Economic Data, the Fed Funds Rate stood at 0.66 percent in February.

In addition to holding down the interest rate, the Fed also engaged in several rounds of what is known as "quantitative easing" (QE) following the onset of the financial crisis. Like lowering interest rates, QE essentially expands the money supply and aims to incentivize more lending by banks, in turn encouraging more spending by consumers and businesses.

Ultimately, the Fed issued three rounds of QE (known as QE1 through QE3) before it began the tapering process, which ultimately wound down the QE process to avoid excessive inflation without shocking the larger economy and slowing down growth yet again.

"The Fed policy in response to [the 2008 recession] was right on point – lower the interest rate to ultra-low levels, expand the balance sheet and have an accommodating policy to help the economy through this," Anthony Curcio, a principal at consulting firm Summit and former credit policy analyst at the Office of Management and Budget (OMB), told Business News Daily. "Now the entire economy is preparing for the prospect of stronger growth, and the Federal Reserve's policies are falling in line with that perspective."

What changes are likely?

While it's unclear whether the FOMC will announce any interest rate increases this week, it's generally expected that increased rates are indeed inevitable in the short term; so much so, that many economists expect multiple rate hikes this year.

"The whole Western world appears on the same page; [European Central Bank President] Mario Draghi said they won't be entertaining any further stimulus measures, and the Federal Reserve has been on that page for a while now," said Bob DeYoung, capitol federal distinguished professor in financial markets and institutions at the KU School of Business and former Fed economist. "One sector in the economy that's convinced the Fed to move is the fact that real wages have begun to increase. We finally have some signs of tightness in the labor market."

As the Fed pivots back to fighting inflation rather than ameliorating unemployment, DeYoung said, he expects two rate hikes within the year.

Curcio concurred, but noted that even with multiple increases before the end of 2017, the fed funds rate will remain historically low.

"I think maybe there will be two or three [rate] increases in 2017. That would put the fed funds rate at about 1.5 percent, which is still low; we're still coming out of that ultra-low policy we've been at for years," he said.

How will the changes impact business?

How might any of these changes impact day-to-day operations for small businesses? First and foremost, the cost of capital will increase. That also means if your consumers are dependent on credit, they might think twice before buying when interest rates rise. DeYoung suggested locking in low rates you might have now, if you have the flexibility to do so.

"If [business owners] haven't already locked in fixed-rate contracts, they need to do that, because interest rates are low now, and going forward, they're not going to be lower," he said.

The good news? Demand is expected to hold steady, and there are no signs of recession on the horizon, DeYoung said.

For Curcio, so long as businesses maintain healthy reserves and keep an eye on their debt service, the increases shouldn't prove too much to handle for most entrepreneurs. While it's important to be aware, he said, don't expect any drastic increases – the Fed will move gradually.

"When rates rise, entrepreneurs relying on credit or relying on customers [who rely] on credit may face additional headwinds," he said. "That being said, one or two rate increases will not be a high rate. We've had healthy growth periods in the '90s where rates were much higher."

"As the economy starts to improve, entrepreneurs need to keep an eye on their interest costs and to make sure they're ready to either lock in those rates or use growth to pay down some debt to make sure [they're] not too exposed," he added.

The long-term outlook

Because the Fed largely reacts to the state of the economy, it's difficult to speculate about the future. However, some indicators can help you infer what might happen down the line in terms of your own industry. According to DeYoung, a key indicator is in the stock market.

"The stock market is trading above lagging earnings, which is a signal that the market expects earnings to stay steady or to go up," DeYoung said. "That's one way to think about the rising stock market – it's predicting that future earnings will be higher than they are today. That's a strong signal today … and I don't believe the current strength of market is based on borrowed money or that it's an asset bubble of any kind."

Curcio said it's important to remember that a lot of what the Fed does is based on external economic conditions. Two major indicators of what the Fed might do down the line are policies set by the federal government, and the ups and downs of major economies throughout the world.

"What [the government] is able to accomplish over the next year is going to tell us a lot about where we're headed," he said. "The other thing is global growth. When growth in China and Europe and other important economies is weak, that's not good for [the U.S.] either. So, if their growth were to falter, then the prospects are not as strong."

The central bank, said Curcio, is not so much working to create economic conditions as it is trying to maintain balance as these scenarios unfold in the real world.

"The Fed is not really driving the economy so much as they are reacting to it. The idea that the Fed's policies are driving the economy is really putting the cart before the horse," Curcio said. "What policies are set beyond 2017 depends on the strength of the economy."

Adam C. Uzialko

Adam C. Uzialko, a New Jersey native, graduated from Rutgers University in 2014 with a degree in Political Science and Journalism & Media Studies. In addition to his full-time position at Business News Daily and Business.com, Adam freelances for a variety of outlets. An indispensable ally of the feline race, Adam is owned by four lovely cats.